The Sunday Times recently published two articles on the above topic. The articles were well written and balanced but one of the heading did not reflect the points made by the article. A person who simply glanced through the newspaper’s heading may think the articles were advocating investing in dividend stocks.
In my field of work, I’ve come across numerous investors who invested based on dividend play. When I asked them how they value these stocks, they had no clue. Apparently they invest based on what they see from blogs and newspaper. Therefore, the mass media plays a very important role in financial education. I personally am against using one’s entire portfolio to invest using the dividend play. In fact, under the best practice portfolio management, dividend yield is not a critical part of the equation. Instead, risk and after-tax and after-expense total return are the most important element.
- If one would look at the top 20 dividend yield showed by the newspaper article, you’ll notice that majority consists of REITS and business trusts. Other investors who are willing to have a slightly lower dividend yield often go to buy preference shares. Preferences share tend to be issued by the banking sector. So an investor who advocates dividend play ends up having a concentrated portfolio in banking sector and REITs. Some stock advisers tell their retiree clients to do that without realizing how dangerous this is. Stock advisers who tell their clients to invest 100% of clients’ retirement money in high dividend yield stocks and preference shares could be in breach of the Financial Advisers Act as it is unreasonable to tell a retired person to put all eggs into just two baskets. There are also other reasons why a stock has high dividend yield. Some of these were also mentioned by the newspaper:
- A company giving high dividend yield could be in distressed. The market has priced the company stock price to be very low as it feared that the company will go belly up. If one would to buy thinking it is undervalued (since the dividend yield is so high), the question is whether does the investor knows something that the market doesn’t or the market knows something which the investor does not. My advice is to respect Mr. Market. Don’t be Mr. Smart Alex if one doesn’t even know how to perform a valuation on these stocks.
- It is also incorrect to say that good dividend yield portfolio is equal to steady stream of income. Far from truth, there is no steady stream of income. If the dividend yield remains static, a drop in stock price results in immediate drop in dividend (in absolute dollar). Can someone tell me how can a retiree live with an income that fluctuates with the stock market? If the dividend needs to be maintained when the stock price drops, it means dividend yield must increase. If dividend yield increase so much, is the company in distress? Should one sell to avoid making further losses? Goto point 1.
- Do not forget about the net worth. The net worth of a person is assets less liabilities. Some people advocate dividend yield play because one can get income without ‘touching’ the capital. I do not blame the lay person for such ignorance but I am often troubled to hear of this advice quite frequently from financial advisers. Let’s say a person invests $500,000 of a portfolio of high dividend stocks which pay dividends of $25,000 yearly (5% dividend yield). Say the financial crisis causes the portfolio to drop to $100,000 although the dividend of $25,000 yearly remains the same. Can anyone tell me it is fine to suffer a lost of whopping $400,000 and sleep well at night? The foolish one will self-console himself by saying that it is okay since the number of shares remain the same and that he can break even after 16 years. Actually, the dividend (in dollar value) would also drop. This ignorance has been formally documented as ‘Self-Control’ in the financial behavior bias. Financial advisers who have truly grasped the ‘Self-Control’ bias that exists in most investors can either do good by advising their clients properly or could make lots of money in commissions by selling products designed to give ‘steady payout’ but with terrible IRR. I do not wish to mention products as product manufacturers could send lawyers’ letters to me.
- A company that give high dividends could be a low growth stock. The newspaper cited a few examples of popular companies which gave out dividends during those periods when these companies were having problems. On the other hand, no dividend was paid during those period which these very same companies were enjoying rapid growth and expanding market shares.
- Some people invest in high dividend yield stocks because these stock prices do not drop as much during the bear run. What they are trying to do is to hedge the portfolio from the downside. Hedging is a different discipline altogether. If they wish to hedge their portfolios, there are other more appropriate instruments to use.
- Some people think that investing in high dividend yield means value investing. Although there appears to be a correlation between high dividend yield and value investing, the relationship is not automatic. Undervalued stock is defined as a company which its stock price is below the fair value. What is the fair value? Fair value is the theoretical value after performing a valuation. I’ve yet to see any investor who actually is able to perform a valuation. I suspect that the only investors in the market that perform valuation are the buy-side analysts simply because they are paid to do so.
So, how should one invest? This is the wrong question. Instead, it is more important to ask how one should get educated in finances. Do not rely on others – whether be it newspaper or hearsay. Nobody will care for you except yourself. Therefore, the only way to attain financial freedom is to self educate.
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